May 12, 2023 - Economy

A defense of short selling

Illustration: Sarah Grillo/Axios

Bank stocks keep wobbling — and short sellers are catching a collective stink eye from politicians, regulators and executives.

Why it matters: Curtailing the maneuvers of short sellers, who try to make money on falling stock prices, could undermine the ability of financial markets to value companies.

  • That mechanism works because prices are allowed to rise when companies do well and fall when they don't.

Driving the news: After a respite, the stock market travails of regional banks continued Thursday, with Los Angeles' PacWest Bancorp falling a bruising 23%.

  • The sell-off came after PacWest disclosed the loss of 9.5% of its deposits in the first week of May.

The big picture: Since Silicon Valley Bank's March collapse kicked off the low-grade banking crisis in the U.S., a feedback loop has emerged between violent swings in bank share prices and deposits rushing out of those banks.

  • In March, SVB's stock price fell 60% in a day, after executives surprised the markets with a sudden announcement that the bank needed to raise cash.
  • The share price implosion simultaneously kicked off a bank run among SVB's well-heeled deposit base, as $42 billion fled in 48 hours.
  • First Republic's demise was similar. Its shares started to plunge, a deposit run also occurred, and the Federal Deposit Insurance Corp. had to take it over and sell it for parts.

Be smart: Such price plunges are manna from heaven for short sellers.

  • They make money by paying a small fee to borrow shares, selling them immediately, repurchasing the stock at a lower price, and returning it to the lender.
  • Short sellers pocket the difference between the higher price at which they sold and the lower price at which they later bought the stock.

The intrigue: Some have argued that short sellers have fueled the bank crisis.

  • By piling the pressure onto falling stocks, they say, shorts create the impression of a panic that can become a reality as depositors get spooked and withdraw their money.

The latest: The argument appears to be gaining some traction.

Yes, but: There's little sign officials are seriously considering "banning" short sales of bank stocks — which was done temporarily during major crises, like in 2008.

Our thought bubble: It's true that some short sellers have a reputation for dabbling in the dark arts, spreading unfounded rumors about companies in order to create a stock price sell-off.

  • But shorts also perform a service to markets, by digging up dirt and shining light on companies that might deserve a bit of legal or regulatory scrutiny.
  • Short sellers have been major players in unmasking massive corporate misbehavior from entities like Enron and Wirecard.
  • Just this week, legendary corporate raider Carl Icahn disclosed that his investment company is under investigation by federal prosecutors, following a public report issued by short-selling firm Hindenburg Research accusing the firm of "Ponzi-like" behavior.
  • (Icahn Enterprises said it was cooperating with the request and added that prosecutors had "not made any claims or allegations against us or Mr. Icahn," Axios previously reported.)

The bottom line: Short sellers are like vultures — or other eaters of the dead — and we mean that in the best sense! They play a key role in keeping the financial ecology on Wall Street healthy. As such, they're best left alone to pursue their profitable — if sometimes unsavory — pursuits.

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